Alexandre Abreu « Euro

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Epilogue: The Euro as Historical Hubris

10. February 2014, von Alexandre Abreu, Comments (0)

The euro is many things at once. Like all other currencies, it is a means of payment, a unit of account and a store of value. Since its inception, it is an attempt to challenge the hegemony of the US dollar as world currency. Insofar as it embodies the transfer of monetary and exchange rate policy from the national to the European level, it is a major step in the process of European integration – albeit one increasingly regarded as ill-advised and out of sequence. But it is also, and somewhat more prosaically, an especially fixed fixed-exchange-rate system – and in that sense, it is also an exercise in historical hubris.

During the course of the 20th century, there have been three major attempts at setting up fixed exchange rate regimes involving significant portions of the advanced capitalist world. The first one was the gold standard of the late 19th and early 20th centuries, which fell apart as a consequence of the outbreak of World War I (as the warring parties felt compelled to adopt expansionary policies in order to finance the cost of war), was resurrected in the mid-1920s, and finally collapsed again as it confronted the structural crisis of the late 1920s and 1930s (otherwise known as the Great Depression). This final undoing of the gold standard was a protracted affair: while Britain and the countries of the so-called ‘sterling bloc’ left as early as 1931, others lingered on until 1938. In historical hindsight, we now know that those countries that abandoned the fixed-exchange-rate regime earlier did a much better job at overcoming the Great Depression (see Figure below, taken from here). Little wonder, then, that the experiment was doomed to fail sooner or later.

Figure

The second major experiment in fixed-exchange rates was the one adopted in the context of the post-1944 Bretton Woods system, in the context of which currencies were pegged to the US dollar, which in its turn was convertible into gold at a fixed rate of US$35 per ounce. It remained in place until the Nixon shock of 1971, whereby the suspension of the convertibility of the US dollar did away with the Bretton Woods fixed-exchange rate system and replaced it with a freely floating currency regime. The proximate cause of its downfall was the US government’s need to finance the Vietnam War, but the deeper underlying cause was the structural crisis of the 1970s (which in fact began to make itself manifest in the late 1960s) and its constraining effect upon profitability, output and fiscal revenue.

And so we get to the third major experiment in fixed exchange rates of the 20th century: the euro, with its predecessor the EMS. The predecessor itself came undone as it confronted the minor crisis of the early 1990s, but still the experiment was carried forward, in a sense through raising the stakes and pressing ahead, in the form of the euro. Then followed the structural crisis of the late 2000s and 2010s – and the rest, well, the rest is history being made as we speak.

Each major fixed-exchange-rate regime experiment of the past 150 years has been undone by each of the structural crises which swept advanced capitalism. Expecting the euro to resist the current structural crisis, at a time when that crisis has scarcely begun to be overcome, while reacting through ever-more-deflationary policies that only exacerbate that crisis, is what I call a fair amount of hubris. A Greek tragedy, as it were.

Europe For Citizens

“This project has been funded with support from the European Commission. This publication reflects the views only of the author, and the Commission cannot be held responsible for any use which may be made of the information contained therein.”

2013: A Year in the Crisis

15. January 2014, von Alexandre Abreu, Comments (0)

So here we are in 2014. As this edition of the Euro Crisis blog draws to a close, it is time to say farewell to the readers and greet the new contributors who will take over and comment on the Euro zone crisis as it develops from here on in. Farewells are also an appropriate time for stock-taking exercises, however, so I think it is appropriate to end my contribution by reviewing what the latest year has meant for the bigger picture of the Euro crisis – at least the way I see it. What progress has been made in the various fronts? And how much closer are we to a resolution of the crisis?

Perhaps not surprisingly, my views are considerably less optimistic than those of most other analysts, many of whom seem to consider that the worse of the crisis is largely behind us. I, on the contrary, believe that we are still far from hitting the bottom, let alone from a resolution. And I also believe that we end the year 2013 in a worse position that we started it.

First, take the superficial element of the crisis: the sovereign debt levels of the eurozone countries. (Superficial in the sense that, as I and many others have argued before, they are a consequence, not a cause, of the crisis.) Between the second quarter of 2012 and the same quarter of 2013 (the latest for which Eurostat has available comparable data), in a context of widespread austerity, absolute public debt levels increased in Austria, Belgium, Cyprus, Estonia, Finland, France, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, Slovakia and Spain. That is to say, in every single eurozone country except for Germany and Latvia. As a percentage of GDP, government debt increased in all 18 eurozone countries except for Austria, Germany and Latvia – including to such remarkable levels as Greece’s 169%, Portugal’s 131%, Ireland’s 126% and Spain’s 92%. Not quite unexpected given the obviously recessive consequences of austerity, but certainly not a sign of progress towards a resolution: greater debt levels mean a greater burden constraining the possibility of counter-cyclical fiscal policy (particularly with the Fiscal Compact in place) and, at least in the Portuguese and Greek cases, a greater amount which will not, for it cannot, be repaid (whether this be through haircuts or sovereign defaults).

More significantly, though, the more fundamental economic variables which encapsulate the nature of the crisis have either deteriorated or remained unaltered during the course of 2013: the massively negative external debt, or international investment position, of the peripheral Euro zone countries (the ‘divergence’ component of the crisis) remained basically unaltered, save for some marginal improvement in the case of Ireland. As for the overall economic performance (the ‘stagnation’ element of the crisis), the outlook also continues to be profoundly depressing: annual GDP growth in the euro area as a whole in 2013 is estimated at -0.4%, while euro area unemployment remains at a record 12.1%. At the same time, the constraints weighing down on that performance have not alleviated: the deleveraging of the private (household and corporate) sector remains to be done, while the spectrum of deflation is an ever-more-present possibility, further worsening the debt overhang and giving rise to recessive debt-deflation dynamics.

At the political and institutional levels, we now have a Fiscal Compact in place which has basically banned counter-cyclical fiscal policy at a time when monetary policy has become well-nigh ineffective; a ‘banking union’ which has not broken the vicious links between troubled banks and troubled sovereigns; a minuscule EU budget slashing all hopes of a recovery led by counter-cyclical policy at the European level; unrelenting insistence on austerity as supposed way out; discontent with the European project growing steadily across the EU; the far right increasingly showing its ugly head as it takes advantage of the European leaders’ incapacity or unwillingness to address the real root causes of the crisis; and a full-fledged humanitarian crisis in large swathes of the European periphery. Hardly grounds for optimism.

Having said this, it is no doubt true that the eurozone crisis has changed its character during the course of 2013: in contrast to earlier on in the year, we no longer experience the crisis as a series of acute episodes, in which the possibility of a dénouement is just around the corner. Instead, we have entered a largely chronic stage, with neither collapse nor improvement in sight. A significant indicator in this respect consists of the interest rate levels on sovereign debt throughout the eurozone: even though the economic outlook has continued to worsen, interest rates, particularly in the eurozone periphery, have fallen significantly over the course of 2013, thus alleviating one of the most acute dimensions of the crisis. By and large a continuation of the ‘Draghi effect’ (the ECB’s manifest willingness to do whatever it takes to prevent defaults in the Euro zone, provided that austerity remains in place), but unintelligible without taking into account the extent to which resistance to austerity has so far failed to materialise at the political level (thus rendering this deleterious low-level political-economic equilibrium much more stable than it seemed 12 months ago).

But this equilibrium will not last, for austerity and deflation are exactly the key ingredients of permanent recession in our current debt overhang situation – and sooner or later the electorate, in at least one of the more chastised countries, will prefer default and the possibility of a euro exit, for all their risks, to the certainty of perpetual impoverishment. In 2013 the crisis turned into chronic stagnation, but we should not let ourselves be fooled by this apparent calm: it only takes one card to bring the house down.

May you have a happy 2014, dear reader – and in these times of crisis, may Europe and its peoples live up to the lofty democratic ideals which the continent has spawned throughout its history.

Europe For Citizens

“This project has been funded with support from the European Commission. This publication reflects the views only of the author, and the Commission cannot be held responsible for any use which may be made of the information contained therein.”

A Not-So-Surprising Accession

9. January 2014, von Alexandre Abreu, Comments (0)

On January 1st, 2014, the day on which the euro had its 15th birthday, Latvia became the 18th member of the eurozone. This accession was prepared over many years and Lithuania is scheduled to follow in 2015, but still this will have come as a surprise to many. Given the predicaments to which eurozone members, and especially the more peripheral and economically-fragile ones, have been subjected to in the last few years, one would imagine eurozone exits to be more likely than eurozone accessions. And yet here we have Latvia proving just the opposite. So what are we to make of all this?

Let us begin by rewinding the tape a few years. Latvia was hit by a severe financial crisis in 2008, as a consequence of the bursting of a credit bubble. In its core, the mechanism was not dissimilar from those which affected most crisis-ridden countries of the eurozone periphery: an inadequate exchange rate (in the case of the Latvian lats, due to its peg to the euro since 2005) giving rise to a mismatch between external economic competitiveness and financial-market inflows and a gradually inflating bubble leading to an inevitable bust triggered by the Global Financial Crisis.

Like the crisis-ridden countries of the eurozone periphery, Latvia requested, and was given, a bailout package (worth €7.5Bn) by the EC-ECB-IMF troika. Quite unlike the peripheral eurozone countries, however, Latvia did have a significant margin to choose between two alternative courses of action when it came to responding to the crisis: given that it had not actually adopted the euro, but merely pegged its currency to it, the choice between internal and external devaluation was a real one. Thus, the Latvian government of the time could perfectly well have abandoned the ERM II mechanism, devalued the lats, undertaken external stabilisation in a way which ensured that the cost of adjustment was borne by the whole of society, and subsequently pursued counter-cyclical fiscal policies. Instead, it chose internal devaluation: keeping the peg and having the overwhelming cost of adjustment be borne by workers through the reduction of ‘labour costs’. The class dimension of this choice is not difficult to see: between having everyone pay (through devaluation-induced inflation) and having workers and the popular classes pay (through wage cuts and austerity measures such as school and hospital closures), the Latvian government chose the latter. And it did so with more than a little cynicism, by attempting to suggest that this choice was made out of social considerations.

Now, we cannot say for sure what would have happened had Latvia made the alternative choice. What we do know, however, is what the selected course of action brought about: a 24% drop in GDP, including a drop by 17.7% in 2009 alone; an increase in unemployment from 8% to 18% in 2008-2009; and the emigration of about one-tenth of the labour force. What the ‘austeritarian’ camp hails as one of its greatest success stories (because of the subsequent recovery: 5.5% in 2011, 5.6% in 2012) is arguably anything but: six years into the crisis, Latvian output remains below the pre-crisis level, unemployment remains at 11% despite mass emigration, poverty and inequality have increased, social services have been slashed, and the demographic fallout of mass emigration will only be felt in earnest further down the road.

What is most interesting to note, then, is that the Latvian government was in a much better position to avoid the social pains of austerity than the countries of the eurozone periphery but nevertheless chose not to do so – and it chose not to do so because what seems like a dysfunctional choice from the point of view of society as a whole, is in fact a perfectly rational course of action from the point of view of particular vested interests. From the standpoint of the financial elite and of the politicians that represent it, joining the euro and abandoning the lats has little to do with the pursuit of noble continental ideals, and a lot to do with further reinforcing of class power. Little wonder then that not more than 22% of Latvians favour joining the euro. And so the tragedy continues.

Europe For Citizens

“This project has been funded with support from the European Commission. This publication reflects the views only of the author, and the Commission cannot be held responsible for any use which may be made of the information contained therein.”

US Treasury versus Germany: New Controversies, Old Debates

7. November 2013, von Alexandre Abreu, Comments (0)

You may have heard about the recent report by the US Treasury criticising Germany’s deflationary economic policies and their harmful effect on the global economy. And if so, you have probably also heard about the reaction that ensued on the part of the representatives of the German authorities, who retorted that there’s nothing wrong with Germany’s “growth-friendly economic and fiscal policy”. Indeed, according to the latter, Germany’s policies constitute a model to be copied by all, including in particular by deficit countries like the US.

My own contribution to this debate will consist of inviting the reader to travel back in time to the United Nations Monetary and Financial Conference which took place in Bretton Woods, New Hampshire, in July 1944. It was a watershed event, which lay the foundations of the global monetary and financial system for decades to come, including through the creation of such structures as the General Agreement on Tariffs and Trade, the International Bank for Reconstruction and Development (which would become the first of the World Bank Group institutions) and the International Monetary Fund. In addition to seeing the birth of what would become known as the ‘Bretton Woods institutions’, the Conference also became legendary in the field of economic history due to the debates between the British delegation, led by John Maynard Keynes, and the American delegation, led by Harry Dexter White. Both men would go down in history: Keynes as an intellectual giant and the ‘father of modern macroeconomics’, White for his ultimately victorious role at the Bretton Woods Conference, but in a strange twist a fate a few years later also due to having been exposed as a Soviet agent in the context of McCarthyism.

In any case, the crux of the disagreement between the British and American delegations concerned which mechanism should be put in place to govern the international financial system and, in particular, to deal with international imbalances. White’s proposal was the one which was ultimately adopted: a fixed-exchange-rate currency regime and the creation of the IMF, tasked with providing emergency financial assistance to countries faced with balance-of-payments crises, under the proviso that these countries adopt contractionary policies aimed at curbing their imbalances. By contrast, Keynes advocated the creation of an international clearing union and international unit of account (the “bancor”), and he wanted the burden of adjustment to be shared by deficit and surplus countries alike: deficit countries would be required to curb demand, but surplus countries would be required to use their surpluses to increase their demand for other countries’ exports. This was built on the acknowledgement that a country’s surplus is, by necessity, another country’s deficit – and on the idea that addressing international imbalances through forcing contractionary policies on one of the sides of the imbalance alone has an overall depressive effect on the global economy. By virtue of political economy (the strength of the creditors’ interests) rather than sensibility, the American proposal won – and that is why throughout the last few decades we have seen IMF delegations imposing austerity, privatisation and deregulation in crisis-ridden developing countries, instead of seeing them confiscate a share of China’s or Germany’s trade surpluses and injecting them back into global demand as Keynes would have had it.

So you see, this most recent of controversies has its roots in a debate that stretches well into the past. It’s not hard to see who’s on the side of reason here: Germany’s policies are not an example to be copied by all because, by definition, not every country in the world can be a surplus country; and its current account surpluses are not “a sign of the competitiveness of the German economy and global demand for quality products from Germany”, as the German authorities have sought to suggest, because, for any level of exports, Germany could have a balanced current account as long as it did not also have an excess of output over spending. The criticism by the US Treasury is therefore entirely to the point. However, it also comes tragically and ironically late: late by about 10 years if we consider the origins of Germany’s ‘wage restraint’ policies; late by about 70 years if we consider what the American delegation stood for at Bretton Woods, and what that meant for the functioning of the global economy in the decades that followed.

Europe For Citizens

“This project has been funded with support from the European Commission. This publication reflects the views only of the author, and the Commission cannot be held responsible for any use which may be made of the information contained therein.”

Pushing on a String: LTRO, Endogenous Money and the Eurozone Crisis

24. October 2013, von Alexandre Abreu, Comments (1)

(slightly wonkish, as Paul Krugman would put it)

At a press conference about a month ago, the President of the ECB, Mr Mario Draghi, raised the possibility of a new round of LTRO (Long Term Refinancing Operation), which, for those less familiar with the topic, consist of large-scale, long-term, low-interest loans to commercial banks across the eurozone, which serve to increase what’s called the ‘monetary base’. While many people think and use the analogy of ‘printing more money’ as the equivalent of undertaking expansionary monetary policy, the reality is that the vast majority of money consists of deposits and is created by the banking sector through credit provision. By extending loans to customers and crediting those loans to their accounts, banks effectively create money (i.e. generally accepted means of payment); and by extending loans to commercial banks, the ECB enables the former to increase the amount of credit, hence money, made available to the economy. The relationship between the monetary base and the total money supply is called the ‘money multiplier’ and the standard view, widely taught to economics undergraduates around the world, is that central banks are largely able to control the total money supply, namely by expanding or contracting the monetary base.
However, this ‘standard’ account of how monetary policy works is shattered to pieces by the abundant evidence provided by developments in the eurozone since the onset of the crisis. As shown in the Figure below (taken from here), between 2008 and 2012 the ECB more than doubled the eurozone’s monetary base (through such programmes as the LTRO), and, lo and behold… there was neither runaway inflation (as most delusional neoclassical economists might have expected) nor anything vaguely resembling a solution to the crisis (as some crude Keynesians might have expected). Quite simply, the enormous expansion of the monetary base did not translate into an increase in the total money supply, i.e. into more credit extended to the economy (M3 in the Figure).

Source: European Central Bank, Statistical Warehouse.

Source: European Central Bank, Statistical Warehouse.

The reason for this, as explained by the largely-ignored Post-Keynesian school, is that banks aren’t actually constrained by the monetary base or fractional reserve requirements when it comes to extending credit: as even bankers themselves will tell you, banks neither function as mere intermediaries between depositors and borrowers, nor do they give out loans to the extent allowed for by the amount of reserve deposits that they hold with the central bank: rather, they extend loans first, credit them into their customers’ accounts and only subsequently do they deposit a fraction of that new credit with the central bank. So in the real world, banks are virtually unconstrained in their ability to create money. Unconstrained by reserve requirements and the monetary base, that is, for in reality they are constrained by other things – crucially, by the demand for credit on the part of potential borrowers, with potentially profitable investment projects, who provide sufficiently good guarantees of paying back the loans.

And that’s exactly where the problem lies. In a situation where aggregate demand for goods and services in the eurozone is constrained by both a massive debt overhang and widespread austerity, many firms are unable to take out additional loans due to over-indebtedness, and the vast majority of the remainder are much less willing to undertake productive investments due to the slim prospects of getting a return on those investments. Thus the attempts on the part of the ECB to control the money supply become like pushing on a string: additional narrow money creation doesn’t actually get pumped into the economy, or only does so to a very limited extent, instead causing the banking system (or some parts of it) to accumulate excess liquidity. Indeed, the reason why the monetary base has been decreasing in the last few months (see Figure above) is that many banks across the eurozone have been paying back their own loans to the ECB so as not to hold on to liquidity for which they don’t have any use. There aren’t that many profitable productive investment opportunities around these days, and even the financing of asset-price bubbles – housing, gold, food derivatives – no longer seems as attractive as it used to.

Now, to be accurate, it’s not necessarily the case that monetary policy has been entirely ineffective: it is probably true that the money supply in the eurozone would have collapsed were it not for the unprecedented expansion in the monetary base. However, the complete breakdown in the stability of the money multiplier shows quite clearly that: i) money is created endogenously in the economy by banks and effectively limited by aggregate demand; ii) we’ve reached a point where narrow money creation is neither inflationary nor expansionary – it’s largely ineffective; and iii) the root cause of the problem is stalled aggregate demand across the eurozone as a whole, owing to rising inequality and over-indebtedness built up over the course of the last 2-3 decades and only made worse by austerity. So whether or not a new round of LTRO is indeed implemented won’t really make much of a difference, at least for the purpose of reviving the eurozone economy and overcoming the crisis.
Want some really ‘structural reform’? Reconnect fiscal and monetary policy, so that the latter is backed up by sufficient stimulus to aggregate demand, and actively promote 5%-6% inflation, so that the debt overhang can be gradually overcome. Of course, the chances of this occurring without major political and institutional overhaul are, well, zero – as are the chances of overcoming the eurozone crisis in the next few years.

The Eurozone Crisis: Finance 2 – Society 0

24. September 2013, von Alexandre Abreu, Comments (0)

An interesting and crucial feature of the eurozone crisis, which hardly ever gets mentioned, is the extent to which it corresponds to a massive, lengthy, disguised and undemocratic process of socialisation of debt relations. What started out as a massive build-up of debt/credit relations between private debtors and private creditors has been gradually converted into debt/credit relations between state debtors and state creditors, with the implication that those who will ultimately foot the bill for the inevitable restructuring of the massive ‘debt overhang’ holding the European economy back will be European taxpayers and peripheral-country citizens, rather than the financial sector and its shareholders. The aim of this post is to show why and how this is so, and to highlight the two main phases that have characterised this process.

By way of background, it is worth recalling that the 2007-2008 Global Financial Crisis and the ensuing Great Stagnation are very much akin to the 1929 Crisis and the ensuing Great Depression: in the build-up to both crises, capital-friendly growth regimes ensured the profitability of investments through direct and indirect wage compression; gave rise to increasing inequality and an increasingly central role of finance; and made up for the detrimental effect (upon aggregate demand) of this rising inequality through a massive increase in private debt. The expansion of credit served as a mechanism not only for recycling profits, but also for households to make up for their relatively stagnant incomes and for firms to expand, merge and modernise. The resulting credit-fuelled demand, again in the build-up to both 1929 and 2007, allowed for ‘roaring’ growth, but sooner or later it had to come up against its limits. And so it did when over-indebtedness reached its ceiling and surfaced as a ‘financial’ crisis, originally emerging in the system’s weakest links (in the first instance, the subprime housing credit market in the US), but ultimately exposing the unsustainable basis on which the entire growth regime was built.

In this sense, the current crisis is indeed global (or at least a crisis of advanced, mature economies as a whole), and it is indeed systemic (for it signals the unsustainability of the neoliberal growth regime). Another aspect to be noticed is the radically different character of this systemic crisis (and the one of the 1930s) vis-à-vis the crisis of the late ‘60s and ‘70s, which was the systemic crisis of a labour-friendly growth regime, brought about by the discouraging effect of declining profitability (in its turn arising out of the workers’ increasing bargaining power) upon investment. And the final background commentary concerns the key difference between the crisis of the 1930s and the current one: while they share the same underlying causes, the crisis of the 1930s took the form of the “Great Depression” because the process of deleveraging was relatively rapid, violent and uncurbed by government action; the current crisis, by contrast, has taken the form of a “Great Stagnation” (after the initial shock in 2007-09) because governments stepped in and halted the process of debt deflation (although the consequence is that there can be no sustained growth, absent inflation or major write-offs, because the ‘debt overhang’ remains in place).

In the eurozone context, this otherwise ‘merely’ socioeconomic process (which is the form it has taken in the US, for example) has taken on an especially serious and international character because of the inherently faulty features of the EMU (the inability on the part of deficit countries to undertake currency devaluations; the requirement that the burden of adjustment falls exclusively upon deficit countries, as opposed to being shared by deficit and surplus countries; the interwoven character of national financial systems and national public finances; and the ‘constitutional’ ban on inflation, which would otherwise provide the means for addressing the ‘debt overhang’).

From this perspective, the story of the eurozone crisis may be summed up in two main phases. Phase 1 corresponded to the socialisation of the debt relation on the debtors’ side: economies whose private sectors were up against the limits of unsustainable indebtedness when the process of debt deflation was triggered in 2007-08 (including Portugal, Greece and Spain) very quickly saw that private debt morph into public debt through two main mechanisms – the direct effect of financial sector bail-outs and the indirect effect of so-called ‘automatic stabilisers’ (declining government receipts and rising expenditures due to economic contraction). Recall that the eurozone’s peripheral economies currently being affected by the so-called ‘sovereign debt crisis’ include countries with vastly different public debt/GDP ratios as of 2007 (36% in Spain, 68% in Portugal, 107% in Greece); what they had in common was the unsustainable levels of net external indebtedness of their economies as a whole by 2007 (78% of GDP in Spain, 87% in Portugal, 115% in Greece). The escalation of peripheral countries’ public debt levels was a consequence, not the cause, of the crisis – and reflected the socialisation of the process of debt deflation on the debtors’ side.

Phase 2 is the one that we’re currently going through: it consists of the process of socialisation of the debt relation on the creditors’ side, as private creditors (particularly banks and other financial institutions in the European ‘core’) are gradually replaced by official lenders as the holders of peripheral countries’ ‘sovereign’ debt. After this debt was socialised on the debtors’ side as of phase 1, the impending inability on the part of the governments in question to service it meant that there were only two options on the table: either those governments defaulted, which would have meant losses for the private creditors, or official lenders like the EC-IMF-ECB troika stepped in (as indeed they did), lending just enough to support the continuing servicing of the debt while private creditors gradually rid themselves of these bonds (as indeed they have been doing over the course of the last 2-3 years).

Given that the public debt/GDP ratios in the crisis countries keeps escalating precisely because of the lethal combination of the dynamics of debt deflation and public-sector austerity (i.e. simultaneous deleveraging across all sectors of these economies, implying recession and decreasing ability to pay), it is increasingly obvious that the sovereign debt of peripheral eurozone countries will eventually and inevitably require a default or serious write-down (not like the Greek one in 2012, which did next to nothing to overcome these structural barriers). This is not a “whether-or-not” question; it’s a ‘when’ question. And when it is that this takes place is important for two reasons: (i) the later the default or write-down occurs, the more the burden will fall upon European taxpayers as a whole as opposed to private creditors; and (ii) the later it takes place, the more time peripheral country governments will have to hold their constituencies to ransom in order to undertake the neoliberal restructuring of their societies in a way which otherwise would never have been possible.

In sum, regardless of the uproar in 2008 against the financial sector, its reckless behaviour and the need to rein it in, the story of the eurozone crisis is a re-run of 2008 in a different, protracted and more subtle form: once again, finance tramples society and forces it to bear the burden of its losses.

 

Europe For Citizens

“This project has been funded with support from the European Commission. This publication reflects the views only of the author, and the Commission cannot be held responsible for any use which may be made of the information contained therein.”

Much Ado about Nothing

26. July 2013, von Alexandre Abreu, Comments (1)

As many readers will have heard or read through other media, the last few weeks have seen a political crisis emerge, develop and finally subside in Portugal. The plot has been a convoluted one, with much toing-and-froing and backtracking, as well as attempts to change the game altogether – but all it came down to in the end was next to nothing. Anyway, now that none of the key players seem to have any cards left to play in the immediate future, it seems like a good time to summarise the events which took place throughout the month of July.

Act 1.
The proximate cause of this political crisis was the resignation of the former Minister of Finance, Vítor Gaspar, on July 1st. Mr Gaspar, a technocrat, was the chief domestic ideologue and implementer of austerity and an all-powerful figure in the centre-right coalition government. His resignation immediately brought on a political earthquake because instead of claiming personal reasons and quietly leaving the stage (as is the standard practice in these cases), he was candid enough to write a public letter of resignation in which he acknowledged the failure of the strategy that has been adopted thus far. Then, on the following day, Paulo Portas, then Minister of Foreign Affairs and leader of the junior coalition partner (the Popular Party, or CDS-PP), seized the opportunity to tender his own resignation from the government. His allegedly irrevocable decision was driven by strictly tactical political considerations: up until now, his party has succeeded in playing a duplicitous role whereby it actively supports austerity measures while simultaneously criticising them in public for leaving insufficient room for “the economy”. As a result of this Janus-faced strategy, the CDS-PP has managed to maintain its poll ratings at around 12% even while the senior coalition partner, the PSD, has been plummeting in the polls (from 39% in the June 2011 elections to 25% at present). However, as even tougher times lie ahead (with the Troika demanding additional permanent budget cuts worth around 3% of GDP in the near future), and with local elections coming up in September of this year, Mr Gaspar’s resignation (and the alleged appointment of a new minister of finance by the prime minister without consulting with the junior partner) seemed like a good opportunity for the CDS-PP to leave the government and avoid the electoral erosion that would surely come about in the next few months.

Act 2.
The resignations of both Mr Gaspar and Mr Portas seemed to signal the government’s imminent downfall, but in fact the play had barely begun. The prime minister, Pedro Passos Coelho, responded by refusing to accept Mr Portas’ public resignation and offering to negotiate. In return for the continuing support of the CDS-PP, Mr Coelho offered the junior coalition partner the leadership of the negotiations with the Troika and control over economic decision-making, in addition to offering to appoint Mr Portas as “Deputy Prime Minister” (a hitherto-inexistent post). This was too much for a party worth 12% of the electorate to turn down, even at the cost of future electoral erosion, so Mr Portas backtracked on his “irrevocable” decision, and the cabinet reshuffling was publicly announced and officially proposed to President Cavaco Silva (who also hails from the PSD). Then, as analysts argued over whether the president would simply confirm the reshuffling or refuse to condone the change in the balance of power in favour of the CDS-PP (thus bringing down the government and calling an early election); Mr Cavaco Silva surprised everyone by attempting to change the game altogether. He refused to follow either option and instead called for broad-based discussions to be held between both coalition partners as well as the main opposition party (the Socialist Party, or PS), with a view to the signing of a “national salvation pact” which would commit all three parties to endorsing austerity regardless of the outcome of the next general election (which would be anticipated by a year to coincide with the formal conclusion of the Troika’s period of supervision in June 2014). Mr Cavaco Silva was thus offering the socialists the opportunity to move into power one year ahead of schedule in return for their formal commitment to maintaining the same political course as the current government.

Act 3.
The president’s surprising proposal was an attempt to set a booby-trap for the socialists. If the latter refused to negotiate, they could be accused of adopting an irresponsible and uncompromising stance in the face of national emergency; if they agreed to endorse the “national salvation pact”, they would be decisively compromised in their ability to simply carry on waiting for the government to fall, and contestation within the party itself would increase significantly. Therefore, it was quite obvious that accepting such a proposal would amount to political suicide on the part of the PS – so what followed was a week of mock negotiations, supposedly leading up to the signing of a pact that at least one of the concerned parties had really no interest in. Eventually, the various parties announced that the negotiations had come to nothing, and did their best to blame each other for the outcome. And the President, whose move failed to bring about the desired results, ended up confirming the cabinet reshuffling that had been proposed a week before and withdrawing the promise of an early general election in September 2014.

Analysis.
The ultimate cause of this political crisis was, of course, the country’s ever-worsening economic and financial situation and the increasingly obvious fact that austerity is spreading social and economic destruction without even bringing public finances under control. As the political fall-out from all this becomes increasingly imminent, cracks have begun to emerge in the ruling coalition and in this instance these were only overcome at the cost of offering the junior coalition partner effective control over economic policy (though this will change nothing of substance). The president seized the opportunity to try and tie the main opposition party to the same pro-austerity course of action through a formal long-term pact, but this was an ill-considered move that had little chance of succeeding. The final outcome is a government whose credibility and popularity, which were already in shambles, have been additionally shaken and whose downfall was only temporarily postponed through offering vastly increased powers to the junior partner. Given that the economic and financial strategy will remain virtually unaltered, the social, economic and political situation will continue to deteriorate, so sooner or later a new crisis will erupt. For the time being, however, it was really much ado about nothing.

Reckless Spending and Excessive Wage Growth: Myths Debunked

13. June 2013, von Alexandre Abreu, Comments (0)

If I were to pinpoint the two most harmful and most often repeated myths at the core of the orthodox account of the euro crisis, these would surely be, first, that the public debt crisis across the eurozone was solely or mostly caused by reckless government spending; and second, that the fundamental competitiveness problem of the economies of the eurozone periphery is a result of excessive real wage growth. Both of these propositions have been repeated so often that they have become a sort of common wisdom – and yet they are both false.

Let us begin with the first proposition. The problem with it, of course, is that it disregards the crucial facts that: a) budget deficits are an endogenous variable whose ‘receipts’ and ‘expenditures’ components are both adversely affected by recession, as indeed they have been in the last few years and especially so in 2008-2009; b) that in many eurozone countries, bank bailouts account for a substantial portion of the budget deficits of the last few years and c) that factors other than budget deficits contribute to public debt levels spiralling out of control – namely the compounding interest charged on that debt, particularly when far in excess of GDP growth (the so-called ‘snowball effect’). Take all of these into account and you get a very different picture from the alleged government largesse.

Of course, there is a lot to be said about the quality of public finance in many of these countries in the last few years or decades, including with respect to ruinous public-private partnerships, tax exemptions and other forms of government capture by vested interests. However, the idea that the simultaneous public debt crises of numerous eurozone countries was caused by governments in all of these countries suddenly and recklessly deciding to increase spending on a whim is, quite simply, not true. What really underlies the public debt crisis is the lethal combination of recession, deflation and the unbelievably Byzantine financial-sector mediation between the ECB and governments (a case-study in financial expropriation for many decades to come). And the corollary is that austerity only makes everything worse and will continue to do so; the only way to solve the (public and private) debt crisis is growth along with moderate inflation (and in some cases the inevitable write-downs).

The second fallacy is also a particularly persistent and pervasive one, and usually relies on showing how the nominal compensation of employees, or alternatively unit labour costs (ULCs), increased in excess of productivity in the eurozone periphery in the last couple of decades, thereby causing competitiveness to deteriorate. In turn, this argument very quickly leads to the conclusion that regaining competitiveness requires sharp wage cuts (internal devaluation). This, too, has been repeated to the point of exhaustion, perhaps most notably and recently by Mr. Draghi in a two-hour session with the eurozone’s 17 heads of state and government in March (see the power point here). Both the argument and the conclusion are plainly wrong, however.

As Felipe and Kumar show in one of the most important (and neglected) papers to have been written on the euro crisis , while ULCs lend themselves to an intuitive and correct interpretation at the firm level (say, the labour cost of producing a table or laptop), at the aggregate level of the economy they are constructed using the economy’s value added, rather than physical quantities, as the measure of output – and therefore the ‘intuitive’ interpretation is no longer appropriate. Rather, these authors show algebraically that, at the aggregate level, ULCs are nothing other than a simple product of two factors: the labour share in the functional distribution of income multiplied by the price deflator (rate of inflation). Allow me to rephrase this: an increase in aggregate ULCs can only be accounted for about by an increase in the labour share of income and/or by inflation. Indeed, we can construct an exactly analogous indicator, called Unit Capital Costs (UKCs), which increases to the extent that the capital share of income increases and/or that there is inflation. And what do we get when we do compute this indicator for the eurozone economies? Refer back to Felipe and Kumar (p. 16) and… lo and behold: with the sole exception of Greece, UKCs increased more than ULCs in every single euro zone country both between 1980 and 2007 and between 1995 and 2007.

The interpretation should by now be obvious: Greece was the only euro country where the functional distribution of income changed in labour’s favour in the last three decades; in all the other countries, the capital share of income increased at the expense of labour; and the extent to which the various economies had greater or lesser increases in both their ULCs and their UKCs was a consequence of differential inflation. So ULCs are really quite distinct from real wages; and following this aggregate approach to its logical policy consequences would entail measures to cut down profits, not wages, in order to regain competitiveness. The real culprits of the differential change in ULCs (or the nominal compensation of employees) across the euro zone is differential inflation and the real wage decrease in the European core – not real wage increases in the periphery.

Promoting competitiveness in the periphery through wage compression is therefore both cynical and wrong – in several different ways. First, workers are being forced to foot the bill twice over; second, the prime determinant of economic competitiveness is not sale price per se, but rather sale prices combined with the pattern of productive specialisation (and recessionary internal devaluations are not helping with the latter, either); and third, the Great Stagnation that the US and Europe as a whole have been living through is a consequence of insufficient demand in the context of a massive (though protracted) process of debt deflation, so compressing wages in the current context is a sure way to further compress demand and curb growth (see here for more detailed information on this).

On some occasions, this erroneous diagnosis takes on an especially aberrant and cynical twist: that’s when the argument is constructed around a comparison of nominal ULCs (or the nominal compensation of employees) with real (i.e. deflated) productivity. Seems obviously wrong even to a first-year undergraduate, wouldn’t you say? Well, that’s actually what many analysts and commentators have been doing for quite a while – and it’s also a key part of Mr Draghi’s story (check slides 9 and 10 in his power point presentation, link above).

So neither is the public debt crisis caused by reckless spending, nor is declining competitiveness a consequence of excessive wage increases. And yet, these ‘fairy tales’ are repeated again and again to make us believe them and are used as a pretext for deleterious and counterproductive policies. We’ve been here before (does the name Heinrich Brüning ring any bells?) – and it wasn’t pretty. Shouldn’t we be taking the lessons from history far more seriously?

Europe For Citizens

“This project has been funded with support from the European Commission. This publication reflects the views only of the author, and the Commission cannot be held responsible for any use which may be made of the information contained therein.”

Dangerous Fantasies and Really Existing ‘Adjustment’

15. May 2013, von Alexandre Abreu, Comments (1)

It has been two years to the month since the original Memorandum of Understanding (MoU) was signed between the ECB-EC-IMF Troika and the Portuguese Government. Elections followed shortly after, bringing into power a new conservative coalition government, which proceeded to implement the structural adjustment programme with unbridled enthusiasm. In the words of Prime Minister Passos Coelho in June 2011, the newly-elected government was “keen to surpass the Troika”.

And, as a matter of fact, it has: successive cuts in government spending, affecting in particular the health, education and social security areas (albeit not the police budget, as befits the ‘austeritarian’ model); sharp increases in user fees, VAT and income taxes; radical changes in labour laws (including slashing unemployment benefits, longer working hours and raising the age of retirement – significant choices at a time of hyper-unemployment); the ongoing privatisation of the remainder of the state-owned sector and numerous other measures in accordance with the austerity/privatisation/deregulation model. In sum, the full neoliberal package in compressed form, of which the economic and social effects have long been well-known from the experience of the global South in the 1980s, though it has to be kept in mind that the first-wave of Structural Adjustment Programmes (SAPs), unlike the current ones, at least made allowance for currency devaluations.

The results speak for themselves. In Portugal, U-3 unemployment shot up from 12% to 17.5% in the last two years, while broad unemployment is currently around 27% and unemployment protection coverage has been significantly reduced. Consumption, investment and therefore GDP have all been freefalling: in the case of GDP, the total reduction since the MoU entered into effect has been around -5%. The current account deficit has been significantly narrowed (in fact, almost eliminated), but that was due to the effect upon imports of the sharp compression of domestic demand and the closure of tens of thousands of SMEs (the brief spike in exports in 2012 was caused by the temporary external depreciation of the euro and was quickly reversed in mid-2012). And most tellingly of all, public debt has kept increasing in both absolute and relative terms (from 108% of GDP in 2011 to 126% at present); for the most part because fiscal revenues kept falling as a consequence of the (largely self-induced) recession. Not yet as catastrophic as the Greek case, but well on its way there – and with a fully compliant government in power.

Now, this is not quite how it was supposed to turn out, was it? Wasn’t the whole idea to bring public debt under control and to unleash the economy’s growth potential by getting rid of excessive regulation, protection and government interference? Wasn’t the slashing of ‘unit labour costs’ (that persistent fallacy, to which I shall return in my next post) supposed to have boosted competitiveness and brought about sustained growth? Well, maybe so in the fantasy world of expansionary austerity and supply-side economics. But of course we all know that austerity is not expansionary and by now we should all know that this crisis (not just in Portugal, but more generally in Europe and across advanced economies as a whole) is being driven by demand, not supply. So why do the Troika and governments across Europe keep insisting on the same recipe? Why have all seven revisions of the Portuguese MoU involved the acknowledgement of a complete failure to attain the targets that were previously set, while carrying on prescribing the same measures yet predicting an imminent recovery? Is it stupidity or malice?

Well, I certainly don’t think that either these decision-makers or their technical staff are stupid people. So, as Sherlock Holmes would put it, that leaves malice as the only plausible explanation. And we have good grounds for pinpointing exactly what malice means here. Studies of the effects of the first-wave SAPs (see here and here, for example) have shown that neoliberal structural adjustment has consistently failed to bring about growth, vastly increased poverty, but, crucially, significantly increased the capital share of national income at the expense of labour. In the Portuguese case and in 2012 alone, the labour share of income dropped from 65% to 62% ̶ and all the gains were concentrated in larger corporations, not SMEs.

This is really about getting a larger piece of a smaller pie and that is why you get a coalition of international and domestic interests pushing forth this agenda. Large capital is bent on increasing its power – even if it destroys the entire European project. There’s not much time left to rein it in and avoid such an outcome.

Europe For Citizens

“This project has been funded with support from the European Commission. This publication reflects the views only of the author, and the Commission cannot be held responsible for any use which may be made of the information contained therein.”

Halftime in Cyprus

27. March 2013, von Alexandre Abreu, Comments (0)

Analysing the latest acute episode of the euro crisis, Cyprus, on March 26th is a bit like writing a match report at halftime: you’re bound to get much of the story right, but if you try to predict the final outcome, you may very well miss – by an inch or by a mile. And as it happens, this particular crisis episode is very much at halftime: after intense negotiations and some extraordinarily clumsy backing and forthing by the Eurogroup and the Cypriot authorities, a deal has finally been brokered that involves a 10€ billion emergency loan, differential treatment of the various banks, austerity (as always), a bail-in of the holders of bonds and deposits over 100,000€ (the big novelty) and no penalty on holders of deposits under that amount (albeit after an announcement to the contrary with indelible consequences, more on which below). However, the banks in Cyprus remain closed to the public as I write, with strict restrictions on movements and withdrawals in place, and no one really knows what will happen once depositors are once again allowed to access their money. My own guess, taking into account the rationality of bank runs and the stage that has been set by the political handling of this crisis, is that the Cypriot banking system may well come crumbling down in a matter of days – and it’s anyone’s guess what that could unleash. We shall soon find out, however, so rather than play the role of Cassandra here, I shall instead dwell on some of the lessons that, even at halftime, we can already draw from the Cypriot crisis – and there are some interesting ones to be drawn.

1. It ain’t over till it’s over. By now, there have probably been a hundred different speeches claiming that the worst of the euro crisis is behind us. In some instances, this has been based on wishful thinking regarding the imaginary virtuous properties of the fiscal compact and structural reform (read: permanent austerity, labour market deregulation and privatisation). In other cases, it has been supported by the peripheral countries’ ‘return’ to the bond markets (really due to the OMT) or the reduction in their current account deficits (mostly a consequence of recession). For all this magical thinking, however, the fact of the matter remains that the eurozone as a whole is in recession and looks set to plunge even deeper; the number of countries that have had to resort to emergency loans has by now reached a handful (Greece, Portugal, Ireland, Spain and Cyprus); the social and economic situation is dire across the eurozone periphery and catastrophic in the hardest-hit countries; and the question in many people’s minds is which country will be next, with several candidates in line. So really, it’s far from over.

2. Every unhappy eurozone member is unhappy in its own way. Each troubled eurozone country has its own set of specific troubles, including the unraveling of massively bloated financial systems, busted housing bubbles, distorted specialisation patterns, loss of international competitiveness, or various combinations of the above. Make no mistake about it, however: there is one common cause underlying all of these epiphenomena, and that cause is an ultimately flawed monetary union without a sovereign to back it.

3. All creditors are equal, but some creditors are more equal than others. Throughout the Eurozone crisis, creditors (typically bondholders) have by and large been treated as sacrosanct. The argument has always been that default or suspension of debt/interest repayment is really not an option, because once you scare investors away, it’s well-nigh impossible to regain their trust. In the Portuguese case, for example, this is used to justify paying out 10 billion euros in interest on public debt in 2013 (more or less equivalent to total public spending on health), even as the economy collapses for lack of domestic demand and even as it is increasingly obvious that a default, or at least major haircut, isinevitable further down the road (public debt amounting to 120% of GDP, with an implicit average interest rate of 5%-6% and absent inflation, can never be repaid by the government of a shrinking economy). Now, what the Cyprus banking crisis has shown is that creditors are not so sacrosanct after all, and it’s alright to scare them away if most of those creditors are not financial institutions from the European core – particularly if there’s a fair chance that these creditors might be scared away from Cyprus and onto Luxembourg or the Netherlands. Indeed, taking into account how all the Cyprus-bashing as an offshore haven for Russian mobsters and oligarchs fails to recall the amount of money laundering that takes place in Luxembourg, the Isle of Man, the Netherlands – and even Germany, for that matter –, one might add that all offshore havens are equal, but some are more equal than others.

4. Once the cat is out of the bag, you probably won’t be able to catch it. The Cypriot banking crisis has been quite extraordinary not only because this is the first time that creditors are called upon to suffer losses as a pre-condition for a bail-out, but also, and especially, because the initial plan involved overriding the EU-wide insurance on deposits under 100,000€ by levying a 6,7% penalty on those deposits. This figure was subsequently reduced to 3%, and then dropped altogether, but by then the cat had already been let out of the bag: depositors in Cyprus, across the Eurozone periphery and in fact across the Eurozone as a whole now know that, under certain circumstances, the European authorities are willing to sacrifice small depositors. Now that’s what I call a sure way of triggering some major bank runs across the Eurozone. But then again, let me not play Cassandra here.

Europe For Citizens

“This project has been funded with support from the European Commission. This publication reflects the views only of the author, and the Commission cannot be held responsible for any use which may be made of the information contained therein.”

Blog Authors

Adriaan SchoutAdriaan Schout

Dr Adriaan Schout is Deputy Director Research/Europe at Clingendael, Netherlands Institute of International relations. (read more...)

Alexandre AbreuAlexandre Abreu

Dr Alexandre Abreu is a 33-year-old Portuguese economist with a PhD from the University of London. Currently he is a lecturer in Development Economics at the Institute of Economics and Business Administration, Technical University of Lisbon, and a Researcher at the Centre for African and Development Studies of the same University.

Almut MöllerAlmut Möller

Almut Möller is a political analyst in European integration and European foreign policy. She is currently the head of the Alfred von Oppenheim Centre for European Policy Studies at the German Council on Foreign Relations (DGAP) in Berlin. (read more...)

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